North Carolina Business Litigation Report

Business Court Blockbuster: If You Only Read One Corporate Governance Case This Year, Make It This One

I'm not sure we've ever had the opportunity to describe a Business Court opinion as "epic" before, but here we are.  On Friday, in State v. Custard, the Court delivered a 70-page, 4-appendix opinion that's the corporate governance equivalent of The Ten Commandments or Ben-HurIn addition to a thorough discussion of directors' duties under North Carolina and Delaware law, the opinion answers four previously unanswered questions posed in the Robinson on North Carolina Corporation Law treatise that occupies a prominent shelf in every North Carolina business lawyer's library.

Custard was a breach of fiduciary duty case brought by the Commissioner of Insurance as the liquidator of Commercial Casualty Insurance Company of North Carolina ("CCIC") against three directors of CCIC.  To make a long story short, CCIC focused on "artisan" liability insurance policies for small contractors and tradesmen in California.  For a period of time, it also offered non-standard auto policies in North Carolina and redomesticated itself from Georgia to North Carolina in 2001, thus becoming subject to NCDOI regulation.  In hindsight, CCIC set its premiums too low and wrote too many policies.  As the Court tactfully phrased it, "CCIC’s growth outperformed the Company’s ability to generate policyholder surplus."  It became insolvent in 2004.

Key points from Judge Tennille's opinion include:

 

Standard of conduct vs. standard of review:  As the Court originally discussed in First Union Corp. v. SunTrust Banks, Inc., 2001 NCBC 9A ¶¶ 22–30 (Aug. 10, 2001), corporate governance is one area of the law in which standards of conduct diverge from standards of review.  The exception to this divergence is a conflict of interest transaction involving a director.

Good faith is not an independent duty:  "[T]here is no duty of good faith separate and apart from the duties of care and loyalty under either Delaware or North Carolina law."  [This is the first of the Robinson questions that the Court answered].  Good faith instead means that "officers and directors have a loyal state of mind: that is, a justifiable, honestly held belief that they are acting in the best interests of the corporation, whether they are making operating decisions or monitoring certain aspects of corporate functions."  Motive is a significant factor, but "[n]either errors in judgment nor negligence establish bad motive."

Context determines director duties:  Director duties are judged contextually, and the duties of a director in one industry may be qualitatively different than those of a director in another industry.  [This is the second Robinson question answered].  In the context of an insurance company, a plaintiff must show that "the officers and/or directors displayed a conscious indifference to risks in the face of clear signals of the existence of problems likely to lead to insolvency."  The insurance industry is based upon risk, so the presence of risk alone is insufficient.

On the other hand, if the directors knew of an imminent threat of insolvency and decided to adopt a "go-for-broke" strategy to write excessive premiums to attempt to survive the insolvency threat, that would be a bad faith action that would avoid the protections of the business judgment rule.  In addition, directors have a duty to act lawfully, so honest regulatory filings take priority over profit-seeking in the insurance industry.

In some situations, both a duty of loyalty and a duty of care may be implicated:  For example, when disclosure is required, both loyalty and care can be at issue.

The duty of loyalty can have an affirmative component:  "[T]here may be circumstances devoid of a conflict of interest in which the duty of loyalty requires a director to act."

Summary judgment is appropriate in some governance cases:  Issues of motive and state of mind of a director do not preclude summary judgment.

The business judgment rule is a gross negligence standard, not an ordinary negligence standard:    [This is the third Robinson question answered].  In other words, "Absent proof of bad faith, conflict of interest, or disloyalty, the business decisions of officers and directors will not be second-guessed if they are 'the product of a rational process,' and the officers and directors 'availed themselves of all material and reasonably available information' and honestly believed they were acting in the best interest of the corporation."  Proof that a decision was "wrong, stupid, or egregiously dumb" is insufficient.  On the other hand, in a self-interest transaction, the standard drops to ordinary negligence.

Hire advisors and follow their advice:  The Court was persuaded that the directors discharged their duties because they took action:  they increased rates, they cut unprofitable insurance lines, and they attempted to raise capital. 

They also relied on third-party actuarial experts.  Although the experts' analysis may have proven incorrect, the Court noted that the methodology was accepted by the DOI.  In addition, a director is statutorily entitled to rely on third-party advisors as long as the director believes the advisor's work is within the advisor's "professional or expert competence."  The data upon which the advisor chooses to rely is a judgment call.

The Court expressed reservation regarding the accuracy of computer models, but reliance upon them still discharged directorial duties (although it may not in the future):

Our recent economic downturn is a stark reminder that computer models of risk are not always accurate and reliance on them can prove disastrous. The entire regulatory scheme and our statutes encourage use of and reliance upon experts and their computer models. Whether that is a good policy is debatable following our recent economic crisis. Nonetheless, it was the policy in effect during the period at issue and is still supported by statute.

Breach of a duty to monitor requires bad faith:  Following the Delaware Court of Chancery's decisions in In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 971 (Del. Ch. 1996) and In re Citigroup Inc. Shareholder Derivative Litig., 964 A.2d 106, 122 (Del. Ch. 2009), along with the Delaware Supreme Court's decision in Stone v. Ritter, 911 A.2d 362, 364–65 (Del. 2006), a plaintiff asserting that directors breached a duty of oversight must show "(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."

The Court identified a non-exclusive list of conduct that would constitute bad faith:

(a) Taking or approving action which, though legal, the Courts find to be inequitable;

(b) Taking or approving action which is not in the best interest of the corporation in order to advance a personal interest, either financial or nonfinancial, in nature;

(c) Knowingly taking or approving action which violates the law and exposes the corporation to liability or other forms of harm;

(d) A sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system or deliberate, conscious, or intentional disregard of duty; or

(e) A failure of the directors of an insurance company to exercise adequate oversight to ensure that the company’s filings with the appropriate regulatory agency charged with overseeing its solvency were in compliance with regulatory requirements.

There is no cause of action for "negligent mismanagement of an insurance company":  Language in State ex rel. Long v. ILA Corp., 132 N.C. App. 587, 513 S.E.2d 812 (1999), does not suggest otherwise because the director in that case engaged in a self-interested transaction, which avoided the business judgment rule and triggered an ordinary negligence standard for his conduct, but the cause of action itself was still for breach of fiduciary duty.

A director's knowledge affects his duties:  As long as a director follows the advice given, and as long as that director has no knowledge to the contrary, he or she may rely upon the analysis of other directors or employees.  The corollary is that, if knowledge levels differ among directors of the same company, those directors may have different duties.  [This is the fourth Robinson question answered].

Stuff happens:  Given the business judgment rule, the Court is skeptical of hindsight in governance cases:  "History teaches us at least three things. First, our knowledge is vulnerable. What we think we know with certainty can and probably will be proven wrong. Second, things will change. Third, bad things will happen, randomly."

 

Full Opinion

 

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Mack Sperling
Brooks Pierce, LLP
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